Economist, Telegraph Columnist, Broadcaster

Eurozone crisis – not over by a long way

“The euro is no longer under existential threat,” said Herman Van Rompuy three weeks ago. “Financial stability has been restored”. Van Rompuy, if you can’t place the name, is President of the European Union. That makes him the most senior policy-maker in Brussels, wielding considerable power over the governments of 28 countries with a combined population exceeding 500m people.

Despite this reality, Van Rompuy has a near-zero public profile. He’s probably best known, not only in the UK but across much of Western Europe, for being the man that UKIP leader Nigel Farage once described as having “the charisma of a damp rag and the appearance of a low-grade bank clerk”.

Earlier this summer, Van Rompuy and his fellow Eurocrats were purring contentedly. The market turmoil seemed over and sovereign bond yields had eased. Those of us still raising concerns about the structural incoherence of imposing monetary union on a group of diverse democracies were, once again, waved away. Warnings of a return to the spiking bonds markets, and European “crisis diplomacy” of last August and September, were dismissed. “There is no comparison between the situation today and the situation nine months ago, when the euro’s existence was threatened,” declared Van Rompuy in mid-June. “That is no longer the case”.

Unfortunately, though, it is. Amid events in Cairo, Wimbledon and the recent adventures of someone called Edward Snowden, you may not have noticed, but the eurozone crisis is back. Last week, the resignation of two key ministers in Portugal caused the country’s 10-year government bond yield to spike 150 basis points in just two days, approaching an unsustainable 8pc.

Since its €78bn bail-out just over two years ago, Portugal has broadly stuck to the consolidation program imposed by the “Troika” – the European Commission, the European Central Bank and the International Monetary Fund. True, the deficit targets have been relaxed, but no-one should claim Portugal hasn’t made serious attempts to get its fiscal house in order. That’s why, just a few short weeks ago, Lisbon was widely expected to “exit” its adjustment phase, and return to raising its own finance, ahead of schedule in the Spring of 2014.

In the wake of this political earthquake, though, which saw the departure of the architects of Portugal’s on-going fiscal adjustment, the markets are now asking serious questions. With a €10bn repayment looming in September, bond yields are back where there were when the country’s bail-out was agreed in May 2011. It’s difficult not to conclude that Portugal will need a second rescue package. That will vaporise its financial credibility and raise very serious political issues in “solvent” Eurozone member state across Northern Europe that will have to foot the bill.

All this comes on top of Greece, of course, which has already received two bail-outs. Having failed, again, to meet public sector reform targets, Athens now appears to be thumbing its nose at its Teutonic paymasters by reversing previously announced cuts to state-sector employment.

The Eurocrats, in response, have threatened to withhold the latest tranche of the country’s massive €240bn rescue package. But with Athens needing to redeem bonds in August, it appears the cash will arrive in installments. That will do little to appease furious voters in Holland, Finland and, of course, Germany.

Angela Merkel faces crucial Federal elections on 22nd September. In the run up to those, the German Chancellor will do everything possible, in terms of easing bail-out conditions, to reduce the possibility of turmoil on European financial markets – which would shatter her reputation for economic competence. The tough rhetoric will continue, of course, but technical concessions will be made to payment schedules and loan conditions, grasped by the bond traders while unnoticed by the broader public. Whisper it, but in the run-up to the German elections, Athens has Berlin over a barrel.

There is a widespread assumption on financial markets that Merkel will indeed secure re-election and, once that’s happened, ECB boss Mario Draghi will get the “nod” to conduct much looser monetary policy in order to try to reflate asset prices. That will mean dropping even the pretense that the Eurozone’s central bank retains any the inflation-fighting culture it was supposed to have inherited from the Bundesbank. But it won’t matter, of course, because by then Merkel will already be safe.

It may not work out like that. While the Christian Democrats are likely to win the most Bundestag seats, Merkel will still be in a messy and unstable coalition. The Parliamentary picture could be altered, also, by Alternative for Deutschland. Germany’s first openly Eurosceptic party, AfD wants a “northern group” of countries to leave monetary union and create a new (revalued) currency of their own.

While not taken seriously by Germany’s supine and deeply conventional media elite, AfD could well gain the 5pc of votes needed to cross the threshold and win representation in Parliament. That could change the terms of the debate in Germany, removing the stigma from insisting on “austerity” in bank-rolled “Club Med” countries and bringing the debate over euro membership into the mainstream. At the very least, AfD’s presence in the Bundestag would complicate the voting arithmetic, placing Merkel under much more pressure when she’s in a tight spot.

Keep in mind, too, that Germany’s constitutional court retains the power to prevent the government from allowing the ECB to buy the bonds of busted Eurozone members, under the so far unused “Outright Monetary Transactions” programme that Draghi apparently agreed with Merkel last summer. The belief that OMT is real, and could be employed in an emergency, was instrumental in quelling last summer’s turmoil on Eurozone bond markets and dampening concerns that the single currency could break up. Yet, the program may well be illegal – and that’s a constitutional sore AfD will do everything it can to pick.

The other rather large fly in the ointment of Eurozone stability is the United States. Recent indications from Ben Bernanke that America could soon slow down it’s $85bn-a-month money-printing habit have caused T-bill yields to spiral. There were further rises at the end of last week, after relatively strong employment figures led to speculation that US QE “tapering” could come soon.

Such is America’s power to make the financial weather that this recent shift in bond prices has crossed the Atlantic, with yields rising not only the in Eurozone, but the UK as well. That’s one reason why Mark Carney, the new Bank of England Governor, moved quickly to provide some preliminary “forward guidance”, issuing a statement last week that rising market interest rates were not “warranted” given that the MPC had no plans to raise the base rate above 0.5. Draghi broke with yet another ECB convention by doing the same, promising to keep Eurozone interest rates “at present or lower levels for an extended period of time”.

Both men are mindful, of course, that even if the US is getting stronger, the highly-indebted balance sheets of governments, firms and households across both the UK and the Eurozone remain far to weak to cope with rising interest rates. So they’re trying to insulate their respective jurisdictions from yield-hike pressures from the US.

Yet the reality is, of course, that the markets set interest rates, and the markets are getting increasingly concerned that, when it comes to sovereign bonds, not least in the Eurozone, the numbers simply aren’t adding up, whatever Van Rompuy says. I hope I’m wrong, but I fear we’re in for a volatile summer.